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1、 Lecture 8 Introduction to Bond Market2What is bondlBonds are given by a issuer to investors (debtholders) usually in order to raise money for the firm lHow do bonds compare with loans?Private financing Close monitoring of creditorBilateral loanBonds issued in private placementPublic financing Acces
2、s to more capital Ability to spread risksMultilateral loanBonds issuedto the publicSecuritization (e.g., CLOs, MBSs)3Basic Features of bondslFixed features of bondsPrincipal (face value/par value): amount bond states is owed to DHslBonds usually have face value of $1,000Maturity: the date the princi
3、pal needs to be repaidCoupon: annual interest that the bond states issuer will paylInterest is usually paid semiannually.lThe coupon rate can be zero.lInterest payments are called “coupon payments”.U.S. Treasury BondslBonds and notes may be purchased directly from the Treasury.lDenomination can be a
4、s small as $100, but $1,000 is more common.lBid price of 100:08 means 100 8/32 or $1002.50lNote maturity is 1-10 yearslBond maturity is 10-30 yearsOther features Optional featureslSecured bond: certain assets serve as collaterallGuaranteed bond: someone other than issuer guarantees paymentlCallable
5、(redeemable) bond: issuer may redeem (pay) bond before maturity, often requires paying call premium (e.g., one years worth of extra interest). Why would issuer want to redeem bonds?lConvertible bond: DHs can convert bond into shareslOther covenants: issuer obligations, breach of which = defaultInnov
6、ation in the Bond MarketlInverse FloaterslAsset-Backed BondslCatastrophe BondslIndexed BondsTreasury Inflation Protected Securities (TIPS).Table 14.1 Principal and Interest Payments for a Treasury Inflation Protected SecurityPB =Price of the bondCt = interest or coupon paymentsT = number of periods
7、to maturity r = semi-annual discount rate or the semi-annual yield to maturityBond PricingPrice of a 30 year, 8% coupon bond.Market rate of interest is 10%. Example 14.2: Bond PricinglPrices and yields (required rates of return) have an inverse relationshiplThe bond price curve (Figure 14.3) is conv
8、ex.lThe longer the maturity, the more sensitive the bonds price to changes in market interest rates.Bond Prices and YieldsFigure 14.3 The Inverse Relationship Between Bond Prices and YieldsTable 14.2 Bond Prices at Different Interest RatesYield to MaturitylInterest rate that makes the present value
9、of the bonds payments equal to its price is the YTM.Solve the bond formula for rYield to Maturity ExampleSuppose an 8% coupon, 30 year bond is selling for $1276.76. What is its average rate of return?r = 3% per half yearBond equivalent yield = 6%EAR = (1.03)2)-1=6.09%YTM vs. Current YieldYTMlThe YTM
10、 is the bonds internal rate of return.lYTM is the interest rate that makes the present value of a bonds payments equal to its price.lYTM assumes that all bond coupons can be reinvested at the YTM rate.Current YieldlThe current yield is the bonds annual coupon payment divided by the bond price.lFor b
11、onds selling at a premium, coupon rate current yieldYTM.lFor discount bonds, relationships are reversed.Figure 14.4 Bond Prices: Callable and Straight DebtYield to CalllYield to call is the yield assuming bond will be repurchased on its callable date. lIf interest rates fall, price of straight bond
12、can rise considerably.lThe price of the callable bond is flat over a range of low interest rates because the risk of repurchase or call is high.lWhen interest rates are high, the risk of call is negligible and the values of the straight and the callable bond converge.Realized Yield versus YTMlReinve
13、stment AssumptionslHolding Period ReturnChanges in rates affect returnsReinvestment of coupon paymentsChange in price of the bondFigure 14.5 Growth of Invested FundsFigure 14.6 Prices over Time of 30-Year Maturity, 6.5% Coupon BondsYTM vs. HPRYTMlYTM is the average return if the bond is held to matu
14、rity.lYTM depends on coupon rate, maturity, and par value.lAll of these are readily observable.HPRlHPR is the rate of return over a particular investment period.lHPR depends on the bonds price at the end of the holding period, an unknown future value.lHPR can only be forecasted.Figure 14.7 The Price
15、 of a 30-Year Zero-Coupon Bond over TimelRating companies:Moodys Investor Service, Standard & Poors, FitchlRating CategoriesHighest rating is AAA or AaaInvestment grade bonds are rated BBB or Baa and aboveSpeculative grade/junk bonds have ratings below BBB or Baa. Default Risk and Bond PricinglCover
16、age ratioslLeverage ratioslLiquidity ratioslProfitability ratioslCash flow to debtFactors Used by Rating CompaniesTable 14.3 Financial Ratios and Default Risk by Rating Class, Long-Term DebtFigure 14.9 Discriminant AnalysisDefault Risk and YieldlThe risk structure of interest rates refers to the pat
17、tern of default premiums.lThere is a difference between the yield based on expected cash flows and yield based on promised cash flows.lThe difference between the expected YTM and the promised YTM is the default risk premium.Figure 14.11 Yield Spreads Credit Default SwapslA credit default swap (CDS)
18、acts like an insurance policy on the default risk of a corporate bond or loan.lCDS buyer pays annual premiums.lCDS issuer agrees to buy the bond in a default or pay the difference between par and market values to the CDS buyer.Credit Default SwapslInstitutional bondholders, e.g. banks, used CDS to e
19、nhance creditworthiness of their loan portfolios, to manufacture AAA debt.lCDS can also be used to speculate that bond prices will fall.lThis means there can be more CDS outstanding than there are bonds to insure!Figure 14.12 Prices of Credit Default SwapsCredit Risk and Collateralized Debt Obligati
20、ons (CDOs)lMajor mechanism to reallocate credit risk in the fixed-income marketsStructured Investment Vehicle (SIV) often used to create the CDOLoans are pooled together and split into tranches with different levels of default risk.Mortgage-backed CDOs were an investment disaster in 2007Figure 14.13
21、 Collateralized Debt ObligationslInformation on expected future short term rates can be implied from the yield curvelThe yield curve is a graph that displays the relationship between yield and maturitylThree major theories are proposed to explain the observed yield curveOverview of Term StructureFig
22、ure 15.1 Treasury Yield CurvesBond PricinglYields on different maturity bonds are not all equalNeed to consider each bond cash flow as a stand-alone zero-coupon bond when valuing coupon bondsTable 15.1 Yields and Prices to Maturities on Zero-Coupon Bonds ($1,000 Face Value)Yield Curve Under Certaint
23、ylAn upward sloping yield curve is evidence that short-term rates are going to be higher next yearlWhen next years short rate is greater than this years short rate, the average of the two rates is higher than todays rateFigure 15.2 Two 2-Year Investment ProgramsFigure 15.3 Short Rates versus Spot Ra
24、tesDetermining Spot Rates (example)lZ1 = 3.62%, Z2 = 3.949%, Z3 = 4.007% The cash flow timeline from the stripped cash flows is as follows:01231-year bond2-year bond3-year bond-96.6463-100.000-100.000+4+3.8+100+104+4+103.8fn = one-year forward rate for period nyn = yield for a security with a maturi
25、ty of nForward Rates from Observed RatesExample 15.4 Forward Rates4 yr = 8.00%3yr = 7.00%fn = ?(1.08)4 = (1.07)3 (1+fn)(1.3605) / (1.2250) = (1+fn)fn = .1106 or 11.06%Downward Sloping Spot Yield CurveExampleZero-Coupon Rates Bond Maturity12%111.75%211.25%310.00%49.25%5Forward Rates for Downward Slop
26、ing Y C Example1yr Forward Rates1yr(1.1175)2 / 1.12 - 1 =0.1150062yrs(1.1125)3 / (1.1175)2 - 1 =0.1025673yrs(1.1)4 / (1.1125)3 - 1 =0.0633364yrs(1.0925)5 / (1.1)4 - 1 =0.063008Interest Rate UncertaintylWhat can we say when future interest rates are not known todaylSuppose that todays rate is 5% and
27、the expected short rate for the following year is E(r2) = 6% then:lThe rate of return on the 2-year bond is risky for if next years interest rate turns out to be above expectations, the price will lower and vice versaInterest Rate Uncertainty ContinuedlInvestors require a risk premium to hold a long
28、er-term bondlThis liquidity premium compensates short-term investors for the uncertainty about future priceslExpectationslLiquidity PreferenceUpward bias over expectationsTheories of Term StructureExpectations TheorylObserved long-term rate is a function of todays short-term rate and expected future
29、 short-term rateslLong-term and short-term securities are perfect substituteslForward rates that are calculated from the yield on long-term securities are market consensus expected future short-term rateslLong-term bonds are more riskylInvestors will demand a premium for the risk associated with lon
30、g-term bondslThe yield curve has an upward bias built into the long-term rates because of the risk premiumlForward rates contain a liquidity premium and are not equal to expected future short-term ratesLiquidity Premium TheoryFigure 15.4 Yield CurvesFigure 15.4 Yield Curves (Concluded)Interpreting t
31、he Term StructurelIf the yield curve is to rise as one moves to longer maturitiesA longer maturity results in the inclusion of a new forward rate that is higher than the average of the previously observed ratesReason:lHigher expectations for forward rates orlLiquidity premiumFigure 15.5 Price Volatility of Long-Term Treasury BondsFigure 15.6 Term Spread: Yields on 10-Year Versus 90-Day Treasury Securities
